Advance Payments for Goods, Services, and Other Items
IRS has issued proposed reliance regs regarding the timing of income inclusion under Code Sec. 451 of advance payments for goods, services, and certain other items. The proposed regs reflect changes made by the Tax Cuts and Jobs Act.
Background. Under Code Sec. 451(a), the amount of any item of gross income is included in gross income for the tax year in which received by the taxpayer, unless, under the accounting method used in computing taxable income, the amount is to be properly accounted for as of a different period.
Reg §1.451-1(a) provides that, under an accrual accounting method, income is includible in gross income when all the events have occurred that fix the right to receive the income and the amount can be determined with reasonable accuracy. All the events that fix the right to receive income generally occur when:
1. The payment is earned through performance,
2. Payment is due to the taxpayer, or
3. Payment is received by the taxpayer, whichever happens earliest. (Rev Rul 2003-10, 2003-1 CB 288)
Rev Proc 2004-34, 2004-1 CB 991, provides a full inclusion method (the Full Inclusion Method) and a deferral method (the Deferral Method) of accounting for the treatment of advance payments for goods, services, and other items. Under the Full Inclusion Method, advance payments are included in income in the year of receipt. Under the Deferral Method, an advance payment is included in gross income for the tax year of receipt to the extent recognized in revenue in a taxpayer’s applicable financial statement (AFS) for that tax year or earned (for taxpayers without an AFS) in that tax year, and the remaining amount of the advance payment is included in the next succeeding tax year after the tax year in which the payment is received.
An AFS is a financial statement that is certified as being GAAP compliant and that is:
a. Of a type filed with the SEC (10-K, etc.); or
b. An audited financial statement used for certain substantial nontax purposes if there is no SEC-filed statement; or
c. One filed with other federal agencies for nontax purposes or certain foreign government agencies, if no better statements exist. (Code Sec. 451(b)(3))
Generally effective for tax years beginning after Dec. 31, 2017, Code Sec. 451(b)(1)(A)(i), as amended by TCJA, provides that for an accrual method taxpayer, the all events test for any item of gross income will not be treated as met any later than when the item is taken into account as revenue in the taxpayer’s AFS.
Code Sec. 451(c)(1)(A) generally provides that an accrual method taxpayer will include an advance payment in gross income in the tax year of receipt.
Alternatively, under Code Sec. 451(c)(1)(B), as amended by TCJA, an accrual method taxpayer may elect to defer the recognition of all or a portion of an advance payment to the tax year following the tax year in which the payment is received, except any portion of such advance payment that is required under Code Sec. 451(b) to be included in gross income in the tax year in which the payment is received. Code Sec. 451(c)(4)(A) defines an advance payment as any payment:
1. The full inclusion of which in the gross income of the taxpayer for the tax year of receipt is a permissible accounting method,
2. Any portion of which is included in revenue by the taxpayer in an AFS (or such other financial statement as IRS may specify) for a subsequent tax year, and
3. Which is for goods, services, or such other items as may be identified by IRS. Code Sec. 451(c) generally contains rules similar to Rev Proc 2004-34.
New proposed reliance regs. IRS has now issued proposed reliance regs that generally track closely to, and expand upon, Rev Proc 2004-34.
AFS deferral method. Under the AFS deferral method in the regs, a taxpayer with an AFS that receives an advance payment must include:
i. The advance payment in income in the taxable year of receipt, to the extent that it is included in revenue in its AFS, and
ii. The remaining amount of the advance payment in income in the next taxable year. (Prop Reg §1.451-8(c) This AFS deferral method closely follows the deferral method of Rev Proc 2004-34.
Non-AFS deferral method. Rev Proc 2004-34 permitted non-AFS taxpayers to use the Deferral Method based on when the income is earned.
IRS has now said that the that Deferral Method using the earned standard is a permissible method of accounting for non-AFS taxpayers. (Preamble) Therefore, the proposed regs also provide a similar deferral method for non-AFS taxpayers (non-AFS deferral method). Under the non-AFS deferral method, an accrual method taxpayer without an AFS that receives an advance payment must include:
i. The advance payment in income in the taxable year of receipt, to the extent that it is earned, and
ii. The remaining amount of the advance payment in income in the next taxable year. (Prop Reg §1.451-8(d))
Definition of advance payment. Prop Reg §1.451-8(b)(1)(i) clarifies that the definition of advance payment under the AFS and non-AFS deferral methods is consistent with the definition of advance payment in Rev Proc 2004-34.
The proposed regs include examples to illustrate that, to the extent certain reward points, e.g., airline miles, are treated as separate performance obligations, such reward points are advance payments. (Prop Reg §1.451-8(c)(8)(xxiv))
Code Sec. 451(c)(4)(B) provides that certain items, except as otherwise provided by IRS, are to be excluded from the definition of an advance payment. Among the items that are excluded from the term advance payment are: rent; insurance premiums governed by subchapter L; and other payments identified by IRS.
The proposed regs provide a list of items excluded from the definition of advance payment that is similar to the Rev Proc 2004-34 list. An additional exclusion is provided for specified goods, as defined in Prop Reg §1.451-8(b)(9), for which a taxpayer requires a customer to make an upfront payment under the contract if
i. The contracted delivery month and year of the good occurs at least two taxable years after an upfront payment,
ii. The taxpayer does not have the good or a substantially similar good on hand at the end of the year the upfront payment is received, and
iii. The taxpayer recognizes all of the revenue from the sale of the good in its AFS in the year of delivery. (Prop Reg §1.451-8(b)(1)(ii))
IRS is considering excluding other items and is soliciting comments regarding what other items it should exclude. (Preamble)
Advance payment acceleration provisions. Code Sec. 451(c)(3) provides that the deferral method does not apply to an advance payment received by the taxpayer during a taxable year if such taxpayer ceases to exist during (or with the close of) the taxable year. Rev Proc 2004-34 provides more detailed acceleration rules.
IRS has determined that rules similar to the acceleration rules provided in Rev Proc 2004-34 are appropriate for the proper application of the AFS and non-AFS deferral methods. The continued use of the deferral method for an advance payment is not appropriate and should be limited in certain situations, such as when the taxpayer ceases to exist, or when their obligation regarding the advance payment is satisfied or otherwise ends. Accordingly, the proposed regs provide rules to ensure the acceleration of an advance payment when a taxpayer either dies or ceases to exist, or when a taxpayer’s obligation regarding an advance payment is satisfied or otherwise ends, except in certain circumstances. Consistent with Rev Proc 2004-34, the acceleration rules do not apply to:
A taxpayer that engages in a transaction to which Code Sec. 381 (carryovers in certain corporate acquisitions) applies;
A Code Sec. 351(a) transfer that is part of a Code Sec. 351 transaction (i.e., a transfer to a controlled corporation) in which:
i. Substantially all assets of the trade or business (including advance payments) are transferred;
ii. The transferee adopts or uses the deferral method in the year of transfer; and
iii. The transferee and the transferor are members of the same consolidated group (Prop Reg §1.451-8(c)(2) and Prop Reg §1.451-8(d)(6))
Advance payments and financial statement adjustments. Code Sec. 451(c) does not specifically address whether the deferral method may be used when an amount is earned in the taxable year but deferred for AFS purposes. The deferral method under Code Sec. 451(c) is an exception to the requirement to include an amount in income when it is received but is not an exception to the requirement to include an amount in income when it is earned under the all events test. Accordingly, consistent with Rev Proc 2004-34, the proposed regs permit deferral of advance payments received to the extent, in the year of receipt, the amount is not included in revenue in the taxpayer’s AFS, and is not otherwise earned in the taxable year of receipt. The amounts not included in gross income in the year of receipt must be included in gross income in the next taxable year. (Preamble)
The proposed regs provide that a taxpayer that defers inclusion of all or a portion of an advance payment must include the remainder of the advance payment in gross income in the subsequent year, notwithstanding any write-down or adjustment for financial accounting purposes. (Prop Reg §1.451-8(c)(3) and Prop Reg §1.451-8(d)(7))
A financial accounting adjustment may occur after certain equity acquisitions. For example, after certain equity acquisitions, the acquiring entity may write down or adjust the target’s deferred revenue in the subsequent year under purchase accounting rules.
Prop Reg §1.451-8(c)(3) and Prop Reg §1.451-8(d)(7) provide clarification for instances in which a taxpayer defers inclusion of an advance payment and is subsequently acquired in certain equity acquisitions. They provide that financial statement write-downs or adjustments to deferred revenue should not be taken into account for federal income tax purposes when determining the proper amount to be included in income under the deferral method. Thus, a financial statement write-down or adjustment to deferred revenue does not result in a permanent exclusion of income for federal income tax purposes.
Short taxable year. If the taxpayer’s next succeeding taxable year is a short taxable year, other than a taxable year in which the taxpayer dies or ceases to exist in a transaction other than a transaction to which Code Sec. 381(a) applies, and the short taxable year consists of 92 days or less, a taxpayer using the deferral method must include the portion of the advance payment not included in the taxable year of receipt in gross income for the short taxable year to the extent included in revenue in an AFS. Any amount of the advance payment not included in the taxable year of receipt and the short taxable year must be included in gross income for the taxable year immediately following the short taxable year. (Prop Reg §1.451-8(c)(4) and Prop Reg §1.451-8(d)(8))
Accelerated cost offsets. Commenters discussed the need for regulatory exceptions to the existing statutory and regulatory timing rules, so that deductions that correspond to the income accounted for under the advance payment rules, could be taken during the same periods as income is recognized.
IRS has declined to provide an accelerated cost offset in the proposed regs. It says that Code Sec. 451(c) and the proposed regs merely change the timing of income recognition, do not preclude any associated reduction or deduction for properly incurred liabilities, and are consistent with existing statutory and regulatory timing requirements that apply to liabilities.
However, with respect to manufacturers and taxpayers with inventoriable goods, it is considering, and is seeking comments, regarding accelerated cost offsets. (Preamble)
Section 451(c) is a method of accounting. Code Sec. 451(c)(2) provides that a taxpayer may elect deferral treatment of an advance payment governed by Code Sec. 451(c), and such election must be made at such time and manner and with respect to such categories of advance payments as specified by IRS. Code Sec. 451(c)(2)(B) provides that the deferral method is treated as a method of accounting and the election is effective for taxable years with respect to which it is first made and for all subsequent taxable years, unless the taxpayer secures the consent of IRS to change to a different method of accounting.
The proposed regs provide that the use of the AFS or non-AFS deferral method is the adoption of, or a change in, a method of accounting under Code Sec. 446. A taxpayer may change its method of accounting to use the deferral methods only with IRS’s consent as required under Code Sec. 446(e) and the corresponding regs. For specific rules as to how to obtain this consent, see Procedures for adopting TCJA inclusion-in-income methods.
Effective date. The proposed regs are proposed to apply to taxable years beginning on or after the date the final regs are published in the Federal Register. Until the date the Treasury decision adopting these regs as final regs is published in the Federal Register, taxpayers may rely on the proposed regs for taxable years that begin after Dec. 31, 2017, provided that they: (1) apply all the applicable rules contained in the proposed regs, and (2) consistently apply these proposed regs to all advance payments. (Prop Reg §1.451-8(f))
Source: Checkpoint Newsstand 9/9/19